Some Big Banks Are Seen in Need Of More Capital

By ERIC DASH and LOUISE STORY

Published: May 7, 2009

The results of the bank stress tests have been trickling out for days, from Washington and from Wall Street, and the leaks seem to confirm what many bankers feel in their bones: despite all those bailouts, some of the nation's largest banks still need more money.

But that does not necessarily mean the banks will get that money from the government. The findings, to be released Thursday by the Obama administration, suggest that the rescue money that Congress has already approved will be enough to fill the gaps. If so, the big bailouts for the banks may be over.

All of this assumes that the economy does not take another turn for the worse, which would result in even more losses at the banks -- and the need for even more money to prop them up. But hopes that the tests will be a turning point in this financial crisis electrified Wall Street on Wednesday and some overseas markets the next day. Financial shares soared, lifting the broader American stock market to its highest level in four months. The Dow Jones industrial average rose 101.63, or 1.2 percent, to close at 8,512.28 Wednesday, while Japan's Nikkei index rose more than 4 percent by midday Thursday.

How well many of the banks fared in the tests seems to have become something of a open secret on Wall Street, where the results, and mere whispers of them, have been the subject of intense speculation.

After news this week that Bank of America and Citigroup would be required to bolster their finances again, word came Wednesday that regulators had determined that Wells Fargo and GMAC, the deeply troubled financial arm of General Motors, would need to do so as well. But regulators decided that American Express, Capital One, Bank of New York Mellon, Goldman Sachs, JPMorgan Chase and MetLife would not need to take action. The official word is due at 5 p.m. Thursday.

The results so far seem to suggest that the 19 institutions that underwent these exams will need less than $100 billion in additional equity to cope with a deep recession, far less than some investors had feared. The question now is, where will banks get that capital?

Most of them would prefer to raise money privately, either by selling shares to the public or a big investor, or by selling some of their businesses. But if that is not enough, the odds are the government will step in.

The thinking is that some banks will ask the government to convert preferred shares that it bought last year, at the height of the financial crisis, to common stock. As a result, the government would become a significant shareholder in a number of banks besides Citigroup.

But under that assumption, no new taxpayer money would go to the banks. The government would merely exchange one investment, its preferred stock, which is much like a loan, for ordinary common shares. The move amounts to shifting public money from one pot to another to ensure that these big lenders -- those deemed too big to fail -- have enough common stock to cushion their potential losses.

This would represent a riskier deal for taxpayers. Whether they get out whole would depend on the stock market. And by exchanging its preferred shares for common stock, the government would also forgo dividend payments on its preferred shares.

''What is positive is that there's a line being drawn,'' said Jim Reichbach, a vice chairman of United States financial services at Deloitte. ''There's a number being put on the table.''

To help cover a huge shortfall, Citigroup has announced plans to convert a portion of the government's $45 billion investment to common stock, which would give the government a stake of as much as 36 percent. Regional lenders like Fifth Third Bank of Ohio or Regions Financial of Alabama could find themselves in a similar boat.

The banks are eager to avoid having the government increase its stake drastically because that would dilute the holdings of the banks' existing shareholders. Bank of America, for instance, is looking to sell businesses and to cash in investments to help cover a shortfall of nearly $34 billion.

Morgan Stanley plans to meet an expected shortfall of $1 billion to $2 billion by selling assets or stock to private investors, a person briefed on the plan said. Citigroup has also sold several big businesses, reducing its large capital deficit to around $6 billion.

In fact, after so much talk of nationalizing banks, the administration's stress tests and capital programs seem to be intended to encourage lenders to take steps to minimize government ownership. The Treasury Department plans to offer a special type of preferred stock that banks can convert to full-voting common shares only as needed. To use it, they will first have to try to raise private capital or do similar exchanges with private investors.

What is more, any gains from asset sales, stock sales or larger-than-expected profits over the next two quarters can be used to offset the shortfalls. That might encourage banks to take bolder action, although some have struggled to find buyers for their businesses, or at least ones willing to pay the prices they seek.

Timothy F. Geithner, the Treasury secretary, said Wednesday that the results of the stress tests might be comforting news.

''It will help lift this fog of uncertainty over the financial system, and I think the results will be, on balance, reassuring,'' Mr. Geithner said Wednesday on ''The Charlie Rose Show.''

Critics say the tests have eroded confidence rather than bolstered it. The tests have occupied banking executives for months and fed the Wall Street rumor mill, adding to the volatility in the markets. Some also ask why the banks were able to negotiate with regulators behind closed doors over the tests and the results.

''The banks are healing themselves, and it could have been done a lot faster if government had gotten out of the way instead of parking the emergency equipment in the middle of the road,'' said Gary B. Townsend, a former banking regulator who now runs his own investment firm.

It may come as a surprise to many people that by most standards, all of the banks that underwent these tests are already adequately capitalized. But regulators are focusing on the amount of capital made up of common stock, the first layer to absorb losses on bad loans.

The government is betting that if banks have a bigger buffer of equity, private investors will be confident enough in the banks' health to pour money in. That should encourage the banks to start lending again.

''This is sending a message that the banks need more capital, but their losses are manageable and the system itself is solvent,'' said Kevin Fitzsimmons, an analyst at Sandler O'Neill. ''Whether it sticks is something else.''

CHART: WHICH BANKS FACE BIGGEST PROBLEMS: Regulators have determined that some of the nation's largest financial institutions need more equity capital to withstand a prolonged recession. The banks are expected to plug some of the shortfalls by selling assets or raising new money from investors. But the banks may also use bailout money that they have already received, by converting some of the government's preferred stock into common stock, increasing the government's stake but diluting existing shareholders. Figures based on known results. (Sources: Treasury Department; the companies; Bloomberg) (pg.A4)